Friday, February 28, 2014

My View

Oh sure, we can reach into our wallets and pull out some currency, or check our bank balance on-line and see how many dollars are in our account, but more fundamentally, what is money?

By itself, "money" has no intrinsic value. As famed investor T. Boone Pickens once said, "...money is just a way of keeping score in life."

And while that is true that it is useful for keeping up with the scoreboard of material possessions and how you compare to your neighbor, money is far more complex that just as a measuring stick or a scorecard.

Vivek Kaul has written an interesting book entitled "Easy Money: The Evolution of Money from Robinson Crusoe to the First World War" that chronicles the story of money from the substitutes to currencies that have come and gone.

In Kaul's book, he details the origins of today's system of money. The Bank of Venice was founded in 1171 and its only business was to hold deposits of gold from merchants who profited from trade with Asia. The Bank of Venice would take the deposit and give a receipt to the depositor.

Soon merchants that owed a debt to other merchants would just trade these receipts when a payment was due rather than going to the bank and withdrawing their gold. These receipts became the first functioning "paper money".

The basis for these receipts, the "money" in the bank was the deposited gold.

It is already obvious what this means for the money supply. When money is created by the deposit of gold, the supply or amount of those dollars becomes self limiting. Gold is a finite resource; a merchant in Venice could not just make it materialize out of thin air, and so his supply of tradable receipts, or money, was limited to the amount of gold on deposit at his bank.

Now fast forward from the Bank of Venice to the United States and our monetary policy. Early in the life of this country, our leaders committed to the "gold standard" which simply meant that if the Federal Reserve created a dollar of our currency, there had to be a corresponding amount of gold held on deposit, much like at the Bank of Venice. This limiting constraint was put in place after early colonial experiments with printing local currencies yielded disastrous results (see: Massachusetts pound).

Now it becomes obvious that for Congress and the President to spend money, the automatic limitation was the ability to provide a corresponding amount of gold to back the dollar. Which is why we had manageable deficits and restrained spending out of Washington.

That changed in 1971. Then President Richard Nixon took the United States off the gold standard when he signed the Bretton Woods agreement.

This meant that our dollar, instead of being backed by a dollar's worth of gold on deposit with the central bank, was now backed by the "full faith and credit of the United States".

Our currency was now a fiat currency, which simply means that it is worth what our leaders say it is worth. There is no other backing of this currency.

Now, as long as our elected leaders show spending restraint and financial common sense; as long as they don't use unfettered access to printing dollars and deficit spending for blatant political purposes....

uh...sorry.

By going to a fiat currency, the restraint that was automatically provided by being on the gold standard was removed. And we all know what has happened over time. Politicians being political animals and having no spending restraints has meant that our national deficits have ballooned to over $17 TRILLION dollars (in reality, it is much worse, but that's another story).

But what also happens to you and to me is not just the specter of higher taxes to pay for this debt, but the fact that our "money" is worth less in terms of buying power.

Think about this: if you have a monetary base- the amount or number of dollars in your economy- and those dollars are tied to a gold standard, that money typically buys a consistent amount of goods and services (I know there are exceptions, but they are too lengthy and detailed for this post). Your money has a stable value.

Now, when a currency goes to fiat status, meaning it is worth whatever the government says it is worth, it buys less.

Why?

Lots of reasons, but one of the primary ones is that there is now risk in holding that currency. There is not gold in a vault that backs it but just the "full faith and credit" of the issuing government. So it costs more to conduct business because the "buyers" of those dollars take on the redemption risk, the risk that the government will be there to redeem those dollars.

This erosion of buying power can be accelerated by any number of things: questions about the stability of the issuing government; questionable monetary policy; and the willingness of the issuing government to honor their obligations.

About that last point...

We have seen governments devalue their currency because it has been their only way out of a debt and fiscal crisis. If you hold that currency and it devalued by 30% because of government decree ("fiat"), then 30% of your currency has vanished.

Imagine how painful that is to the holders of that currency and the citizens of the country where that has occurred.

And if you want a recent lesson and example, just Google "Argentine currency devaluation" and read the first couple of news items.

What leads to this sorry state of affairs?

Huge deficit spending, weak leadership, questionable monetary policy, just to name a few factors.

And if the United States sounds like Argentina, you are right.

The saving grace for the U.S. is that at the moment, the dollar is still the world's reserve currency, but that is slowly changing.

And if the dollar loses its status as the sole reserve currency for the world, we may look more like Argentina than any of would dream possible.